2023: January “Audible”

Adjustment to my 2023 Investment Playbook

The recessionary trade (long bonds short stocks) has not panned out in January, thus proven premature. The bond market continues pricing in deep recession via severely inverted yield curve whereas the stock market has not priced in recession whatsoever (SPX at 4100 implies 8%-10% earnings growth in 2023 which doesn’t have a snowball’s chance in hell of happening). This stark divergence needs some exploration.

After 40 years of extreme global financialization, we now live in a bass-ackward world where liquidity leads financial markets and financial markets lead economies. So we should never use economic data to predict financial markets. “Financial conditions” (keep in mind this is a reflection and not predictor of asset prices) are counterintuitively loosening right now (despite supposedly draconian Fed tightening in 2022):

This can only be from actual increase in liquidity (not just from the Fed but the private sector and global money supply), —the primordial force behind “financial conditions” :

In fact, global liquidity could be in the nascent stage of a 2-year UP cycle.

Clearly, this is responsible for U.S. equity melt-up since the Oct 2022 bottom (notwithstanding a declining USD which — despite “loosening” financial conditions — should make the U.S. less of a “cleanest dirty shirt” for global money flow):

The surprising increase in liquidity (at a time of Fed tightening) can be traced to drawdown of the Treasury’s general account and the PBOC’s credit impulse (a la the much ballyhooed “China Reopening”). Not much comes from cross-border flow into the US (quite the contrary, the current flow is from the US to EM — typical of USD carry trade during times of declining USD). Insofar as the private sector, not much comes from corporate cash flow or bank lending, but some probably comes from shadow banking (private equity investments come readily to mind). And retail wash-sale buyback is definitely a factor: Speculators piling back in the same beaten-down, profitless tech sector after the 30-day wash-sale rule expired on tax loss selling at the end of ’22. Last but not the least, corporate buybacks rage on (fueling SPX forward earnings multiple to its highest level):

This global liquidity spurt is currently “getting in the way” of (more accurately, “delaying”) recession from draconian rate hikes. It is also the reason for higher-than-target inflation for longer and thus impetus for higher FFR for longer (which increases chances for recession, — but not necessarily Black Swans because banks are in a much better place today than in 2007). Lastly, it may well be ephemeral because the M2 growth is actually declining in the U.S.:

Since the GFC in 2008, M2 growth is synonymous with debt growth and essentially a Ponzi scheme to keep the financial markets from imploding. As all Ponzi schemes, the rate of inflow must not slow, let alone go negative. Well, it is going negative now! Indeed, redemption gates are going up in REIT and other funds as refinancing existing debt (at much higher interest rates) becomes increasingly difficult. The long feared “debt spiral” (endgame to currency reset) may have begun, even as temporary liquidity spurt keeps equity speculation going.

Meanwhile, massive short covering of China's (tech) stocks based on the China reopening story may also be short-lived because the China credit impulse (a key component of the global liquidity spurt) is actually on the wane alongside its manufacturing activities:

And despite PBOC money printing, China's GDP continues its downtrend. Lackluster performance of industrial metals attest to this (and implies weak end-user demand from the West). China’s economy is now so unstable that it cannot create the same liquidity it did 14 years ago (which resulted in massive misallocation of capital and a humungous fixed asset bubble it is still unwinding now).

Domestically, the best validation of Tara is institutional flow favoring money market yield over total equity yield (one reason staples have not done well is because their dividend is paltry next to MMF yield as recession deepens):

But systematic CTA buying is triggering hedge fund short squeezes and technical buy-signals, subsequently dragging in mutual fund cash deployment.

As well, tax-loss sellers piling back in the lowest quality but most beaten up (read: shorted) stocks has resulted in a greed sentiment regime (reflecting “beta grab” of short squeezes (themselves a source of liquidity which loosens financial condition) by money managers whose careers are on the line), portending the next move to be on the downside:

As corroborated by peak dumb money index:

And short term oscillators being in overbought territory:

The up leg since Oct 22 is long in the tooth and has broken above the 200 DMA, — a legitimate concern for short positions. This leg is most likely an up wave-B to the multi-decade down wave-A that was the Oct low. In this case we're already close to (50% retracement) target. (Indeed, daily oscillators are now in overbought territory and poised to reverse down.)

The fly in the ointment, however, lies in monthly MACD (see blue circled areas), signaling we may actually be in grand cycle wave 4 (i.e. the 2022 market peak was merely grand cycle wave-3). Considering wave-3s take at least as much time as wave 1, this is plausible. Monthly oscillators being near oversold position (see chart below) lends further credence to this scenario:

Further corroborating this thesis is the amazing fact that the FTSE is at its all time high despite all the economic woes plaguing the UK (mania characterizes wave-5s)!

Finally, the USD:JPY currency pair trending up is typically bearish for stocks (note steep rise in 2022). It is now trending down:

In conclusion, the equity market rally since October 2022 lows can be rationalized this way: We are in the eye of the storm between multiples contraction and earnings recession (there is a nine months delay between Fed tightening and recession), and opportunistic traders (human and algos alike) are capitalizing on the calm (aided by temporary liquidity spurt) to force a fierce short-squeeze on the junkiest stocks (indeed they have risen the most), enticing dumb retail money to bottom fish.

Since the up-leg is not yet abating, notwithstanding the severely inverted yield curve being a persistent headwind to financial conditions, compelling negative fundamentals for enterprises, and short term overbought condition, cover half of short position either on Wed (Feb 1) FOMC pullback or when daily MACD hits bottom, whichever comes earliest (and re-short later in the year if wrong).

Meanwhile, .25% rate hike in March is all but certain, and (a final) .25% rate hike in May is now highly likely (per Powell’s Feb FOMC speech, notwithstanding more dovish voting members on the FOMC this year). So wait till May before pulling the trigger on 6-month T-bills.